Thank you once again to the Paul Woolley Centre for the opportunity to speak
to this conference. This is the third time I have spoken at this conference.
Two years ago, I discussed how to identify and communicate about risk.
Last year, I talked about some policy approaches that might be used to respond
to those risks. Today, I would like to step back a little and reflect
on society's tolerance for financial stability risks, what we might or
might not give up to reduce the risks we face, and how some structural aspects
of the financial system might affect the risks it poses.

More Stability Is a Choice

The global financial crisis spurred a huge, international effort to reform financial
regulation.[1]
That work is ongoing, and will be for some years. I don't think there is
any doubt about why the crisis spurred such reforms. The events of the crisis
showed that banks in many jurisdictions needed more capital; that governance
and risk management needed to improve; and that risks in derivatives markets
and shadow banking needed closer scrutiny. But at a more fundamental level,
the crisis showed that the prior settings of regulatory policy in some countries
had not achieved the degree of financial stability that society actually wanted.

Society has only so much appetite to impose risks on its members. In particular,
it has only so much appetite to impose risks on people who had little or nothing
to do with the creation of those risks. We therefore have laws, regulations
and other measures to reduce the chance that a bad event might happen. Think
of pool fences, guardrails on the sides of roads, or special car seats for
children. We also have insurance, welfare systems and tort law to cushion the
blow if a bad event does happen.

How much of each of these measures we as a society choose depends on how much
risk we are willing to bear – or to impose on others – as well
as on the price we are willing to pay to avoid or ameliorate those bad outcomes.
Different countries make different choices about these issues. That is why
the Australian authorities have consistently argued that international regulatory
agreements need to be tailored to national circumstances. The global minimum
standards, such as the Basel III framework, are just that – minimum standards.
Countries are within their rights to choose to strengthen the local implementation
of those minimum standards if need be.

Sometimes some additional conservatism is needed because of particular features
of each country's financial system. A good example of this is the longstanding
tighter setting of prudential capital rules on housing loans in Australia,
relative to what the Basel framework requires.[2]
Housing is a large part of the Australian banking system's asset base.
It therefore makes sense to allow for that concentration, even though housing
loans are individually a lower risk than some other things banks could be doing
with their balance sheets.

In other cases, the authorities might choose to be a bit more conservative to
reflect that society is a bit more risk averse than in some other countries.
As a central banker, I am not in the business of claiming to have insights
into the national psyche. But it seems to me fair to say that Australia is
not a society that tells people who have suffered misfortune that they are
entirely on their own. Nor does our society apply the ‘caveat investor’
principle to all financial dealings. We have consumer and investor protection
rules to protect non-experts. We also have regulation to reduce various kinds
of abuse. We are also cognisant that actions that are rational for an individual
can collectively result in a bad outcome. And that is where financial stability
mandates become highly relevant.

At the same time, it would not be ideal if people were completely insulated
from the risks that they knowingly and willingly take on. A financial stability
mandate does not mean that policymakers should try to ensure that nobody anywhere
ever loses money. It does not mean that nobody anywhere should ever default
on their loans. And it certainly does not mean that no individual financial
institution anywhere should ever fail. What it does mean is that the harm done
to the real economy, to the innocent bystanders, should be as small as can
be reasonably managed. That implies that policies to promote financial stability
should include a mix of pre-emptive measures to head off trouble, and post-event
responses to deal with trouble when it does occur. In other words, the authorities
should both ‘lean’ against risk and ‘clean’ up the
mess.

The global regulatory reform program has done a lot on the ‘lean’
phase. Banks hold more capital, so they are less likely to fail. Supervision
has been enhanced in the countries where this was needed. And compensation
practices in financial firms have been overhauled and attract more scrutiny
from regulators.

There is still plenty of work that has been agreed internationally, and is in
the process of being implemented in each country. Much of this work to be done
relates to the ‘clean’ phase. For example, a lot is being done
to ensure that banks, and other important parts of the financial system, can
be resolved effectively if they do fail.

More Stability Might Not Mean Less Efficiency

As with any major regulatory reform, the reform program spurred by the crisis,
especially the higher capital requirements, has met with claims that it might
harm growth. That is, some commentators argue that the reforms are trading
off stability and efficiency. It is sometimes claimed that requiring banks
to hold more capital will hold back credit growth, and thus economic growth.

In my view there are a couple of problems with this argument. First, it assumes
that credit growth causes economic growth. There is some truth to this. If
credit supply is constrained, for example because the financial sector is weak,
that can hold back growth. It would be a ‘credit crunch’, of the
kind described by Chairman Bernanke in his earlier academic work.[3]
There does seem to be some element of a credit crunch in places like the United
Kingdom and the euro area at the moment. But slow credit growth can also be
the result of weak demand, not constrained supply. Causation doesn't flow
all one way.

Second, we should not assume that all financial activity needs encouragement.
If a certain business line is only economic when too little capital is held
to cover the risk it entails, it is not a business that should be pursued.
For all the concerns about the financial system's ability to serve the
real economy, it must be remembered that banks also have extensive connections
with other parts of the financial system. That includes their activities in
plain vanilla wealth management, but also some of the more rarefied segments
like hedge funds, structured investment vehicles and other parts of the so-called
‘shadow banking system’. In the lead-up to the crisis, this part
of the business became increasingly important for some banks, especially a
few in major financial centres. Some of this was legitimate redistribution
of risk to those best placed to bear it, but I question whether it all was.
Lending to the real economy need not be the business line that is most affected
by regulatory reform.

Third, the recent crisis has shown how severe the costs of a crisis to the real
economy can be. There is empirical evidence suggesting that recessions are
deeper and longer if they are instigated by a banking crisis.[4]
A cost-benefit assessment suggests that society would be willing to pay some
price to avoid those harms. The best available estimates of that trade-off,
uncertain as they are, do imply that the regulatory reform program is a net
benefit to society.[5]

A final point about this issue is that some regulation is essential to create
stability. There is no trade-off. Society benefits greatly from the existence
of a safe, liquid asset that people can rely on to make payments, and which
they can trust will not suddenly decline in nominal value.[6]
But we've learned over the centuries that the private sector cannot produce
truly safe, truly liquid assets on its own. Without prudential supervision,
central bank liquidity and some form of depositor protection, the private sector
cannot offer an asset that is both safe and liquid even in bad times. The recent
crisis was in part a story of people learning that assets they had been happy
to treat as safe, weren't completely safe. And they learned that lesson
over and over in the crisis with repo finance, asset-backed commercial paper,
super-senior collateralised debt obligation (CDO) tranches, auction rate securities,
money market funds – the list goes on.

All Creatures Risky and Even Riskier

Another, subtler, critique of financial regulation argues that stability carries
the seeds of its own destruction. The idea behind this line of argument is
that imbalances always build up during the good times. So the longer you go
without a small crisis, the larger the crisis you will have eventually.[7]
Small, regular crises are therefore supposedly helpful and cleansing, and policymakers
resist them at the economy's peril. Having gone for more than 20 years
without a serious recession or major banking problem, Australia is going to
be a good test of this particular hypothesis – though hopefully not any
time soon!

Underlying this argument must be some kind of model. Usually, it seems to be
a metaphor as model – that of a forest fire. In a forest, the argument
goes, kindling builds up over time. If it is not reduced through regular burn
outs, expect a conflagration eventually.

It's useful to put these kinds of verbal arguments back in terms of the
model implicitly underlying them. You can then find all the previously unstated
assumptions, and decide if they are appropriate to the question. In the case
of the forest fire, I think the metaphor only goes so far, so I'm not convinced
of the argument. For a start, this model assumes that kindling always builds
up at the same rate. Is the forest that suffers few fires building up more
kindling? Or is it just that some kinds of trees are less prone to burn? In
Australia, we are only too aware that eucalyptus trees are more flammable than
many other species. Perhaps some kinds of banks are more prone to burst into
flames – metaphorically, that is – than others.

When we talk about different species of banks and other financial institutions,
we are really talking about business models. Within the banking industry globally,
there are many different kinds of banks with different niches, risks and balance
sheet structures. You can classify them any number of ways, but one useful
dimension to think about is a spectrum with investment banks at one end, commercial
or retail banks at the other, and so-called ‘universal’ banks in
the middle. This graph shows that those labels correspond to different balance
sheet structures (Graph 1).

Graph 1

Investment banks, like Morgan Stanley as shown here, or Goldman Sachs, have
a lot more trading assets than banks with different business models. Commercial
banks like Wells Fargo mainly have loans. Universal banks like JPMorgan or
Citigroup have a bit of both. You can see the same distinction on the liabilities
side. Investment banks tend to have more wholesale and repo funding, commercial
banks less so. Even starker are the differences in off-balance sheet business,
which aren't shown here. Investment banks tend to have larger and more
complex derivatives positions than commercial banks, and depending on a country's
accounting rules, these positions are in some cases not on the balance sheet.
The larger derivative positions of investment banks arise partly because of
their own trading business and partly because they intermediate between other
banks that wish to transfer risk or hedge particular exposures.

This distinction between different business models is a strategic choice, and
not just an artefact of past restrictions built into the US regulatory structure.
You can see it in banks around the world. In Australia, the big four banks
are clearly at the commercial end of the spectrum. Much of their business involves
servicing household and business customers in Australia and New Zealand. As
the next graph shows, their trading books and other securities holdings are
a relatively small part of their business (Graph 2).

Graph 2

What does this mean for financial stability analysis and policy? Certainly different
business models lead to different balance sheet structures, and therefore different
risk exposures. Unlike the trees in the forest fire model, these differences
come from conscious choices, about their business models and strategy. Trees
don't choose how flammable they are, but banks can choose their risk profile.
That said, tree species do evolve in response to the environments they face,
just as individual banks and whole banking systems adjust to the incentives
they face.

One of the most powerful sets of incentives for banks is, of course, the regulatory
arrangements they are subject to. This brings me back to the international
program of post-crisis regulatory reform. In designing these reforms, it has
been essential to consider how the regulated industries and their counterparties
will respond. Those responses can change not just financial firms' behaviour
but sometimes their entire business models.

This isn't simply a concern that the reforms will push business out of the
supervised banking industry and into the shadow banking system, though that's
part of the issue. It's also a concern to ensure that the different elements
of recent reforms are not in conflict with each other. There have been some
elements that do seem rather at odds.[8]
For example, we want to ensure that financial institutions can absorb losses.
Yet it would not make sense to demand that ‘bail-in-able’ wholesale
debt should be so high that funding profiles became less stable. Likewise,
we want derivatives markets to be safer and more transparent. But we do not
want to change the incentives so far away from uncleared over-the-counter markets
that it weakens risk management in other ways. Some risks cannot be adequately
hedged by a standardised, clearable product. There will still need to be bespoke
but uncleared transactions that better match those risks. An uncleared trade
might reduce risk by more than an imperfect hedge, or worse still, not hedging
the risk at all. There needs to be balance.

There is another issue in the international regulatory reform program that we
should also be mindful of. The reforms have gone a long way to promote international
consistency in financial regulation. For example, for the first time, the Basel
Committee is assessing how faithful each country's reforms have been to
the agreed Basel III framework. And there will be further work on the consistency
of risk weights across banks for the same exposure. This is important and helpful
work. But in ensuring consistency, we do not want to create a monoculture,
with all its members being vulnerable to the same risks because they face the
same incentives. There is something to be said for allowing some diversity
of business models, so the whole system doesn't collapse from a particular
shock. That is one kind of diversity that I think needs more attention. It
also needs to be allowed for when we design regulation.

Another important dimension of diversity is that the financial system is made
up of more than just banks. Insurance firms, pension funds, asset managers
and financial infrastructure providers are all part of the landscape. They
each have different capacities and face diverse risks. They, too, need to be
regulated in ways that are adapted to that diversity.

So far today, I've been talking about risk, regulation and different business
models. None of that is a typical concern of macroeconomics and monetary policy,
which are the usual fare at central banks. Macroeconomics doesn't have
a monopoly on wisdom when it comes to financial stability issues. Banking and
finance are important sources of insight; so are disciplines like accounting,
actuarial science, complex systems and industrial organisation. And we should
never forget the lessons of economic and financial history.

Over the past few years at the Reserve Bank, we have found ourselves delving
into areas as diverse as the mathematics of networks and the intricacies of
tax law.[10]
None of that is taught in a conventional macroeconomics major. The things a
financial stability policymaker typically needs to know don't look much
like conventional macro. In financial stability departments, being able to
read a balance sheet is at least as useful as being able to solve for the rational
expectations equilibrium of some macroeconomic model.

I don't think there needs to be a special financial stability degree the
way there are degrees in economics or finance or actuarial studies. Speaking
as someone who did major in macroeconomics, I've found you can learn a
lot of what you need on the job. Clearly though, the building blocks of financial
stability education are already there. There is a lot the world already knows
about financial analysis, about credit risk, about banking crises. There is
also a lot already known about financial history, organisational behaviour
and complex systems. And although it's fair to say that we know rather
less about asset pricing dynamics and how some of these micro-level behaviours
build up to macro-level instability, I do believe that academics and practitioners
can work together to expand the frontier of knowledge here, too.

Central banks need to harness those diverse sources of expertise in their financial
stability function. That means that the monetary policy function, which naturally
has an intellectual culture based on macroeconomics, mustn't unduly overshadow
contributions from other perspectives. Economics as a discipline has a bit
of a reputation for colonising other domains, but central banks need to give
space and respect to a range of disciplines.

I can see two ways to avoid problems around this issue, both of which are definitely
practised here in Australia. One is to ensure that we recruit from a broader
stream, including but not limited to macroeconomics. The fact that the Reserve
Bank also has a longstanding policy mandate for payments system stability and
efficiency helps here: that area needs microeconomists and lawyers as well
as macro/finance skills.

Another way is to ensure that financial stability policy is a collective endeavour.
The dominant economics culture of central banks finds a counterpoint in the
accounting, finance and actuarial cultures of prudential supervisors, and in
the more legal-oriented cultures of securities regulators. We can learn a lot
from each other, and gain a lot from working together. Our mandates differ
somewhat, but they are consistent.

Some diversity, with overall consistency. That sounds like something that would
make a financial system, and the regulation that shapes it, strong enough to
achieve stability.

Thank you for your time.

Endnotes

Thanks to Elliott James and Rachel Adeney for their assistance in preparing this
talk.
[*]

Without getting into the details, there are two main elements to this more conservative
setting. Banks and other lenders in Australia using the ‘standardised’
approach to capital adequacy are required to hold more capital against higher-risk
mortgages, such as low-doc loans or loans with high initial loan-to-valuation
ratios, than the Basel framework requires. Banks using the ‘advanced’
approach must assume a minimum 20 per cent loss given default on mortgages
in their risk models, compared with the 10 per cent minimum required in the
Basel framework. The latter measure acts as a substitute for a major housing
downturn. Because Australia hasn't had a severe housing downturn in many
decades – the 1890s comes closest – banks do not have severe
enough data to put into their models. These capital rules are designed to
ensure that banks and other deposit-takers hold enough capital to withstand
a severe housing downturn.
[2]

Gary B Gorton describes this type of safe asset as ‘information insensitive’.
See Gorton GC (2010), Slapped by the Invisible Hand: The Panic of 2007, Oxford
University Press, Oxford.
[6]

This is, of course, a version of Hyman Minsky's ‘financial instability
hypothesis’. See Minsky H (1982), ‘The Financial-Instability
Hypothesis: Capitalist Processes and the Behavior of the Economy’,
in C Kindleberger and J-P Laffargue (eds), Financial Crises: Theory,
History and Policy, Cambridge University Press, Cambridge.
[7]